The pause in the bond rally that began in the early part of the year is just that: A pause. Further ...
The pause in the bond rally that began in the early part of the year is just that: A pause. Further tightening of interest rates by the major central banks cannot be ruled out, but in our opinion it will prove unnecessary and would have to be reversed.
This scenario is especially relevant in the US and the UK. The combination of expensive labour, higher borrowing costs, higher energy prices and foreign currency losses will eventually overwhelm the benefits from increased productivity. In the US these productivity gains are large but elsewhere less so.
The result should be a reduction in company profits and therefore a cutback in investment. A reduction in spending comes partly from a reduction in the amount of available income after petrol purchases. A doubling in the amount you have to pay just to get from A to B is bound to impinge on your spending plans. Also higher interest costs are affecting the over-borrowed US consumer. The lack of stock market gains will be the final excuse to retrench.
All of the above can be applied to the UK markets. The UK economy is likely to slow over the coming six months and the chances of a more severe slowdown have risen recently. The central bank has kept interest rates high and consistently talked about putting them up higher. Manufacturing in the UK has had no relief from a fall in the currency because so far it has principally been against the dollar. Our main export markets are in Europe, whose currencies have fallen against sterling.
The service sector appears to be slowing as well, raising the chances of a more pronounced reduction in overall growth.
The UK bond market will have to negotiate a difficult path over the coming two months. A complicated issuing calendar will have to be digested as the market copes with not only the Pre-budget review but also changes to pension fund bond allocations.
Over the next few months the benchmark gilt indices will be lengthened as the authorities use the Budget surplus to buy back shorter-dated gilts. This will cause some anxiety for index trackers. Another potential minefield for sterling bond investors is the change in pension fund guidelines.
The last Budget contained a significant increase in spending, due to come into play next year and beyond. The bond market was not too concerned by this pro-growth stance as the majority of the extra spending was to be funded by a greater than expected revenue stream. Fiscal austerity is here to stay and gilt supply will continue to be reduced over the next 12 months at least.
One fly in the ointment is the reduced popularity of the current UK government. Markets do not generally like change and it is worth bearing in mind that a UK General Election is looming next year.
Paul Brain is senior fund manager at Investec Asset Management
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